Conclusion: Mounting political pressure is incrementally supportive of our bearish long-term thesis on the Japanese yen vs. peer currencies. Additionally, we update our fundamental outlook on the Japanese yen, JGBs, and Japanese equities across multiple durations.
Our fundamental research view on the yen remains particularly bearish over the long-term TAIL and of all the potential ways to play our Japan’s Debt, Deficit and Demographic Reckoning thesis, shorting the yen vs. peer currencies (particularly the USD) remains our highest conviction idea.
As always, however, we don’t want to be short the yen at every price. In fact, as we highlighted in our MAR 30 note titled “Digging Deeper Into Japanese Sovereign Debt Risk”, our bearish intermediate-term view on global equities and high-grade sovereign S/T interest rates leads us to expect further JPY strength vs. peer currencies over that duration – absent a material acceleration in Japanese sovereign debt crisis risk (more on that later).
MOUNTING POLITICAL PRESSURE IS BEARISH FOR THE YEN OVER THE LONG-TERM TAIL
From a political perspective, the pressure upon the Bank of Japan to end deflation grows seemingly by the day. In just the last few weeks alone, there has been a handful of what we’d consider critical signals in support of our view that the Bank of Japan’s balance sheet will expand materially over the long-term TAIL as the BOJ is forced to pursue its recently-adopted +1% inflation target:
- MAR: BOJ Governor Masaaki Shirakawa – openly opposed to accelerated BOJ financing of JGBs – agreed to a 30% pay cut;
- MAR: BOJ Deputy Governor Kiyohiko Nishimura was questioned by parliament on the idea of the BOJ adopting a measure similar to the Fed’s Operation Twist;
- APR: The Liberal Democratic Party – the ruling Democratic Party of Japan’s largest opposition party – rejected BNP Paribas SA Economist Ryutaro Kono’s appointment to the BOJ’s monetary policy board, citing his hawkish lean and lack of commitment to combating deflation by any means necessary (the 9-member BOJ board currently has two vacant seats and appointees need to be approved by both houses);
- APR: Shirakawa and Prime Minister Yoshihiko Noda met for ~1hr to discuss monetary policy; at the current pace (16 YTD), Shirakawa is on pace to exceed last year’s record total for Diet appearances;
- APR: PM Noda announced that Economic and Fiscal Policy Minister Motohisa Furukawa will lead new ministerial meetings on the topic of overcoming deflation; Finance Minster Jun Azumi, Economy, Trade and Industry Minster Yukio Edano, and Financial Services Minister Shozaburo Jimi will all be in attendance at the regular meetings;
- APR: The DPJ asked four of the five remaining non-governor BOJ monetary policy board members to meet later this month to discuss countering deflation.
All told, we expect this level of political pressure to continue accelerating indefinitely, with the composition of the BOJ board likely getting incrementally dovish in the near term and finally cracking in a material way from a balance sheet perspective after Shirakawa’s departure as BOJ Governor one year from now. Recent moves in Japanese breakeven rates are also signaling this view.
AVOID THE WIDOWMAKER!
As previously mentioned, we do not expect the yen to depreciate dramatically in the intermediate term unless a near-term Japanese sovereign debt crisis becomes a probable risk (as opposed to the tail risk that it remains currently). Until that happens, we’d expect both JGBs and Japanese equities to trade as expected in an environment of yen strength. We quantify those relationships in the charts below.
Japanese equities, which we flagged last week as having snapped their immediate-term TRADE support, have corrected -5.9% since the USD/JPY cross peaked on MAR 14 (+3.5%). There remains additional downside risk from a mean reversion perspective, given the Nikkei’s +21.3% YTD melt-up to its MAR 27 cyclical top. 10yr nominal JGB yields are down -6pbs (-6.5%) from their cyclical top on MAR 15.
Turning our attention to our daily handicapping of the probability of a near-term Japanese sovereign debt crisis, the latest data points would suggest increased, but not heightened risk:
We are encouraged by Japan’s ability to get through the MAR maturity calendar unscathed. That said, however, the 2Q maturity wall looks quite hefty on a quarterly basis, suggesting to us that Japan isn’t out of the woods just yet from a refinancing risk perspective.
Turning to the new issuance calendar, the latest L/T bond auction (last Wednesday; 10yr maturity; ¥2.3 trillion offered), which was the first of FY12, posted the lowest bid-to-cover ratio (2.73%) and highest average yield (1.01%) in four months.
We’re also closely monitoring the performance of Japanese bank equity and CDS, given their risk exposure to the JGB market (25.1% of assets). There’s nothing overly worrisome to report here, with the exception of Nomura’s 5yr CDS, which is up +56bps (+21.2%) from a trough of 257bps on MAR 19 to 320bps.
One of the key indicators we’ve been watching to signal to us increased risk in the JGB market are L/T-S/T nominal yield spreads. This is due to our expectation that the JGB yield curve would steepen in an environment where a structural increase long-term inflation expectations and deteriorating credit fundamentals would slow the growth in demand for L/T JGBs relative to the short end of the curve – where default risk is not imminent – in an environment of accelerating supply. Recent trends here would suggest decreased risk of this event.
Other key indicators we’ve been monitoring are L/T JGB CDS. Both the 5yr and 10yr tenors have really come in over the last few months, declining -51bps and -43bps, respectively, from their YTD highs to 104bps and 141bps, respectively. The credit default swaps market is definitely not signaling increasing risk of a JGB sovereign debt crisis – an event that could potentially lead to default given Japan’s heavy debt service and refinancing burdens.
We’ve compiled a list of quotes and statements below that we think are helpful in gauging consensus sentiment around a near-term JGB market crisis. While no one person/entity’s thoughts are omnipotent, we often find taking nuggets like these in conjunction to be helpful in vetting our own research conclusions:
- “The risk of a tumble in government bond prices would increase if taxation and social security reform are left unsolved for years… Japan must quickly overhaul the tax and social security systems to prevent government borrowing costs from spiraling in the next decade.” [Yasuhiro Sato, chairman of the Japanese Bankers Association]
- “The country’s financial assets are dwindling with the aging population dipping into savings. Any delays to the reform that’s being debated may raise concern that bonds may be unable to be absorbed domestically in the long run, say, in 2022. But there are no signs of a JGB price plunge in the near term." [Yasuhiro Sato]
- Refer to slide 80 of our presentation for a view of what this looks like graphically
- “Japanese bond yields may rise toward the summer because of the cyclical economic recovery, uncertainty about the Bank of Japan’s policy stance and Japan’s political risks.” [Tetsuya Miura, chief market analyst at Mizuho Securities]
- Japan risks going down the same road as Greece as the cost to fund the world’s largest public debt rises in [the] years ahead. When local investors reach their limit for funding the nation’s bonds, the Bank of Japan will either have to monetize the debt or we will need foreigners to purchase bonds and yields will jump to 3 percent. That will be the start of Japan becoming Greece.” [Takatoshi Ito, deputy vice finance minister from 1999 to 2001]
Japanese sovereign debt and currency risk poses a challenge for even the most sophisticated investors to wrap their heads around due to the idiosyncrasies of the JGB and JPY market(s). That said, however, every challenge poses a great opportunity for those looking to beat the odds and nail the major moves from both a timing and directional perspective. We will continue to update our thoughts on this subject, depending on the level and proximity of risk.